Equity markets in China finished mixed on Monday, with Shenzhen stocks losing ground and Shanghai shares clawing their way to positive territory as the weekend stimulus package launched by Beijing failed to ignite markets that have been reeling from a three week long rout.

The benchmark Shanghai Composite Index added 2.41 per cent, or 89 points, to finish at 3,775.91, after rising as much as 7.8 per cent at open.

The Shenzhen Component Index, which is comprised of more smaller and medium-sized companies, lost 1.39 per cent, or 170.29, to close at 12075.77.

The latest move by China came in a commitment from the People’s Bank of China providing liquidity for state-backed margin lender China Securities Finance Corp after a weekend meeting of the State Council, China’s cabinet, which was chaired by Premier Li Keqiang.

The move underscored the extent of the state’s exposure to a debt-driven unwind that has erased some US$2.8 trillion from mainland Chinese stock markets in a three-week long rout.

A total of 21 of the country’s largest brokerages announced plans to pool funds to buy shares in the market and some large firms such as developer China Vanke announced a 10 billion A-share buyback plan on Monday to boost their company’s shares.

Greece hit the Hong Kong share market hard as shares were battered by a sell-off on Monday sparked by the vote in the European country rejecting the bailout package of international creditors.

The city’s de facto central bank, the Hong Kong Monetary Authority, said it is ready to supply liquidity as Hong Kong stocks tumbled over 1,000 points in late afternoon trade on Monday.

“The HKMA stands ready to provide liquidity support to the banking system should it become necessary to do so. Investors are advised to remain calm and to manage their risks prudently.”

This wiped off all gains earned since the market rally began on April 8 which at one point pushed the index up by 13 per cent in April and allowed the index to hit a seven-year high above 29,000 points.

The index is now back to the level before mainland Chinese mutual funds were allowed to invest in Hong Kong after a Beijing rule change.

The brevity of a relief rally on Monday morning shows investors are yet to be convinced by the slew of measures announced after a weekend meeting of the State Council, China’s cabinet, chaired by Premier Li Keqiang.

“Senior policymakers realise that, because of the leverage in the system, stock market declines create a ripple effect that could damage the wider economy, so this is all about preventing a spreading panic that could trigger a systemic crisis,” Lu Ting, head of research at Hong Kong-listed mainland brokerage HTSC, told the South China Morning Post.

An initial 7 per cent rally for Shanghai and Shenzhen A shares in response to measures that included liquidity support for the state-backed margin lender China Securities Finance Corporation from the central bank had faded by the lunch break, with the Shenzhen Composite Index falling back into negative territory.

The People’s Bank of China (PBOC) move came after the mainland’s biggest brokerages agreed to set up a 120 billion yuan (HK$150 billion) fund to prop up the market and promised not to sell shares in proprietary accounts while the Shanghai index remained below 4,500 points – roughly 20 per cent above its current level. Some 25 mutual fund firms also pledged to inject capital into vehicles they manage.

Analysts at Bank of America/Merrill Lynch likened the package to the “big bazooka” measures promised in 2008 by then US Treasury Secretary Hank Paulson to stop the spreading crisis that was tearing at the heart of the global financial system.

“We assess that there is still a fairly high chance that (the) market may fall sharply again at certain point over the next few months, unless the PBOC makes an open-ended commitment to support the market,” they wrote in a note to clients. “If the PBOC becomes the main source of market-supporting liquidity, we expect the central bank’s credibility to be hurt and the RMB (yuan) may come under pressure.”

Broking firms are at the heart of a web of margin finance – loans to buy stocks – that currently totals around 2 trillion yuan officially, with an estimated 3 trillion yuan more borrowed through unofficial channels by many of the country’s 90 million registered investors who generate about 80 per cent of daily stock market turnover through 257 million equity investment accounts.

“A stock market crash would be undoubtedly painful, which if materialising, could shave 0.5 to 1 percentage point off real GDP growth in the following 12 months. In that case, policy easing, both monetary and fiscal, would have to step up,” estimated Wei Yao, chief China economist at investment bank SG.

1929 Flashback

Reader Jeremy writes ...

Hello Mish,

The way China is conducting stimulus is eerily similar to what happened right before the 1929 stock market crash. From the SCMP:

"A total of 21 of the country’s largest brokerages announced plans to pool funds to buy shares in the market and some large firms such as developer China Vanke announced a 10 billion A-share buyback plan on Monday to boost their company’s shares."

On October 24 ("Black Thursday"), the market lost 11 percent of its value at the opening bell on very heavy trading. The huge volume meant that the report of prices on the ticker tape in brokerage offices around the nation was hours late, so investors had no idea what most stocks were actually trading for at that moment, increasing panic. Several leading Wall Street bankers met to find a solution to the panic and chaos on the trading floor. They chose Richard Whitney, vice president of the Exchange, to act on their behalf.

With the bankers' financial resources behind him, Whitney placed a bid to purchase a large block of shares in U.S. Steel at a price well above the current market. As traders watched, Whitney then placed similar bids on other "blue chip" stocks. This tactic was similar to one that ended the Panic of 1907. It succeeded in halting the slide.

The Dow Jones Industrial Average recovered, closing with it down only 6.38 points for the day. The rally continued on Friday, October 25, and the half day session on Saturday the 26th but, unlike 1907, the respite was only temporary.

Over the weekend, the events were covered by the newspapers across the United States. On October 28, "Black Monday", more investors facing margin calls decided to get out of the market, and the slide continued with a record loss in the Dow for the day of 38.33 points, or 13%.

Moral Hazard

Whether this plays out anything like Lehman or 1929 remains to be seen. Crashes are rare.

Regardless, it was idiotic that margin debt got as extreme as it did. It is even more idiotic to bail out speculators burnt by margin.

Bailout attempts of this nature will either fail miserably or produce an even bigger moral hazard bubble with more leverage and speculation.

That the Chinese central bank and brokerages would act as they did is a sure sign of genuine trouble in China's banking system.

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